And who can blame them? Small-cap funds have been performing well against the competition for years now.

If you look back five years at all the domestic stock fund categories of mutual funds, Small-Cap Value and Small-Cap Blend are ranked as the fourth and fifth best-performing fund categories over that period. Only real estate, natural resources, and utilities did better. The average returns of funds in those two small-cap categories were 12% and 11%, respectively.

Looking at the last three years, small-caps slipped in the rankings. Small-Cap Value and Small-Cap Blend were sixth and eighth, respectively, but still posted strong returns.

The overall small-cap market was pretty outstanding in 2006, though. The Russell 2000 Small-Cap Index was up 18.37% for the year. But that return masked a precipitous drop in the second half of the year, and now in 2007, the Index is only up 0.97%.

We’re not surprised that the Russell is barely above breakeven right now. That’s because small-caps tend to prosper in times of economic growth, and lag when times are bad. And the signs for bad times are scaring everyone at the moment. The yield curve is still sending out recession warnings, housing looks negative in both the short term and the long term, and employment numbers and retails sales look pretty weak.

So, what does it mean for those of us devoted to the world of small-cap stocks?

Well, not much really.

You’ll hear many pundits advising investors to rotate out of a portion of small-caps into a greater portion of larger capitalization stocks.

Our advice would be to continue buying the greatest stocks at deep values — period.

Of course, over the long term, small-caps have a record of outpacing most other asset classes. But now, stock picking is critically important.

And no matter what small-caps do in the short term, these three small-cap investment themes should bring us sizable profits…

The Battle for Medicare Drug Price Negotiations

The House passed a bill to let the Federal government become chief drug price negotiator for Medicare, which could upset an apple cart many were satisfied with. It’s in the Senate now. But we have an investment in Small-Cap Strategy Report (SCSR) that should profit no matter what the outcome. It’s already up 2.8% since we first recommended it, and we think there is a lot of upside left in this one.

Bottom line: If the government becomes Medicare’s lead negotiator, look for generic manufacturers to rise. If things stay as they are with the private sector doing all of the price negotiations, look for under-priced, branded-drug companies to flourish.

Preparing for Peace While Profiting from War

Defense stocks were on a tear in 2006, and some continue to do so even in the face of an Iraq pullout by U.S. forces. We have one defense play in SCSR that realizes wartime buying of its products will not always be at a fever pitch, so they are expanding their peacetime products… products that could revolutionize the car industry. This one is currently down 3% so far, but I’m really pounding the table about it. It’s a screaming buy today.

The Little Known Way to Curb Global Warming

Cars have been targeted as a primary source of the proliferation of greenhouse gasses in the atmosphere. Whatever you personally believe about global warming, the fact of the matter is that automobiles will face ever-increasing emissions hurdles. There are several ways to make cars emit fewer harmful gasses, but another way to attack the problem is simply to make cars more efficient. We’ve found a little known company that does just that, and they supply an elite clientele who can literally afford to buy anything from anyone. So far, this idea is up only 2.2%, and hopefully SCSR readers buy more of this great name.

As always, it’s a tremendous time to buy great small-cap stocks.

Until next time,
Craig
March 22, 2007

Current Trends in Small-Cap Stocks was originally featured in the Penny Sleuth.